Introduction

The euro was introduced in 2002 as the single currency of the European Union, consolidating the largest trade bloc in the world and creating one of the world's strongest currencies. However, the accumulation of massive and unsustainable deficits and public debt in a number of peripheral economies soon threatened the eurozone's viability, triggering a sovereign debt crisis. The crisis highlighted the economic interdependence of the EU, while also underscoring the lack of political integration necessary to provide a coordinated fiscal and monetary response.

Beginning in 2010, the EU and IMF began providing bailouts for crisis-ridden economies. But the demands of wealthier states, particularly Germany, that loans be conditioned on strict austerity measures contributed to a deepening pessimism, inciting popular unrest and toppling governments. In early 2015, elections in Greece brought the anti-austerity Syriza party to power, putting the country on a collision course with policymakers in Brussels, Frankfurt, and Berlin.

Even as some of the periphery has emerged from recession, the specter of a Greek exit from the eurozone—combined with economic stagnation, hesitant reforms, and rising nationalism across Europe—has once again called into question the sustainability of the monetary union. As the continent struggles, the European Central Bank, under the leadership of Mario Draghi, has stepped in with unprecedented bond-buying and monetary-easing programs.

Building the Postwar Common Market

Following World War II, France's Jean Monnet, considered the founding father of modern Europe, argued that economic integration would be vital to eliminating intercontinental conflict. In 1951, he became the chief architect of the European Coal and Steel Community, at the time the most significant step ever taken toward European integration. "The way to build the new union was through incremental steps toward economic integration that one day would lead to political integration," wrote Franco Pavoncello, the president of Rome-based John Cabot University, in May 2011.

The next major step toward European integration was the 1957 Treaty of Rome. The treaty, in which France, Germany, Italy, Belgium, the Netherlands, and Luxembourg established the Common Market and the European Economic Community (EEC), abolished trade tariffs between members, sparking rapid growth. Europe’s expansion accelerated in the decades that followed, especially with the signing of the 1986 Single European Act, which facilitated the development of an internal European market, allowing for the free exchange of capital, goods, and people.

Maastricht and Monetary Union

The move toward a common market soon revealed a need for monetary coordination. In 1992, the Maastricht Treaty formally created the European Union, and led to the circulation of the euro currency in January 2002. Nineteen of the twenty-eight EU member states are part of the eurozone, while other EU states, including Bulgaria, the Czech Republic, Hungary, Poland, and Romania, are required by treaty to eventually join. Denmark and the UK were granted exemptions.

Under the Maastricht convergence criteria, states joining the euro must have their economic houses in order, and the 1997 Stability and Growth Pact requires ongoing fiscal compliance. Specifically, states must ensure inflation below 1.5 percent, budget deficits below 3 percent of GDP, and a debt-to-GDP ratio of less than 60 percent. To meet these criteria, many countries had to adopt strict budgetary reforms.

In practice, however, these standards were not consistently applied, paving the way for future problems. "There was shockingly weak due diligence in assessing the suitability for entry into the euro, and equally weak application of the few rules that were supposed to police its operation," explains hedge fund manager Jason Manolopoulos in his 2011 book Greece's Odious Debt. The eagerness of EU officials to develop a large and competitive eurozone led them to overlook these warning signs.

Global Meltdown and Sovereign Debt

The effects of this negligence were not immediately felt: The periphery states initially thrived, propelled by unprecedented access to credit from other eurozone members. But following the global financial meltdown of 2007–2008, liquidity dried up, revealing unsustainable deficits and large public debts. By 2010, sovereign debt crises—most pronounced in Greece—had spread throughout the periphery, and by 2011 the EU and the IMF had bailed out Greece, Ireland, and Portugal.

"There was shockingly weak due diligence in assessing the suitability for entry into the euro, and equally weak application of the few rules that were supposed to police its operation." –Jason Manolopoulos, author of Greece’s Odious Debt

Greece was ground zero. Its debt-fueled boom was untenable, and in November 2009, it was revealed that Greece had manipulated its balance sheets to hide the scale of its debt—its 2009 deficit exceeded 15 percent of GDP, more than twice the official numbers. A report by George Mason University's School of Public Policy (PDF) summed up: "The roots of Greece's fiscal calamity lie in prolonged deficit spending, economic mismanagement, government misreporting, and tax evasion."

Sovereign Bailouts

A Greek default would have sparked its exit from the euro and potentially a domino effect of crises across Europe. Thus, in May 2010, the troika of the European Commission, the ECB, and the IMF created the European Financial Stability Facility to provide Greece with a $163 billion bailout loan. In exchange, the country would implement strict spending cuts and tax hikes.

As Greece struggled with austerity in the following two years, the terms of its bailout evolved. An October 2011 rescue plan provided Greece with a second bailout worth approximately $178 billion, including a "voluntary" haircut in which private holders of Greek debt accepted a 50 percent writedown. But a political crisis forced Prime Minister George Papandreou to resign in favor of a so-called technocratic national unity government in 2012. In November 2012, bailout terms were again renegotiated, this time including lower interest rates for Greece’s loans.

Ireland and Portugal were next. Unlike Greece, Ireland's troubles were spurred by a bank crisis resulting from its 2008 housing collapse. As Ireland’s banks took massive losses from the crumbling housing market, the government stepped in to support the financial system. By November 2010, the country was forced to seek a $112 billion EU-IMF rescue package in exchange for austerity measures. As a result, the Irish economy experienced one of the most severe recessions in the eurozone, with output decreasing by 10 percent and unemployment rising from 4.5 percent to nearly 13 percent in 2010.

Portugal’s foreign debt-financed deficit—over 10 percent of GDP in 2009—meant that when investors withdrew, the country could no longer finance itself. By May 2011, the country needed a $116 billion bailout package. The conservative government of Prime Minister Pedro Passos Coelho, elected in June 2011, immediately set about implementing austerity measures as Portugal fell into its deepest recession in decades.

Contagion

At the end of 2011, the center of the debt crisis shifted to Europe’s larger countries, including Italy—the eurozone's third largest economy. Given Italy’s more than $2.6 trillion in public debt, however, a bailout was not an option.

Instead, then-Prime Minister Silvio Berlusconi was forced to step aside in favor of a new government, led by economist Mario Monti, charged with carrying out budget cuts and reforms to pensions and labor markets. The center-left Democratic Party narrowly won the subsequent 2013 national elections, leading to a succession of leaders culminating in the charismatic Matteo Renzi, who in 2014 became Italy’s youngest prime minister. Renzi, too, has struggled to implement structural reforms and pull Italy out of recession.

Spain, like Ireland, faced a housing-market bust that left its banking sector highly exposed. By 2012, it was forced to request a bailout, and EU leaders agreed to use eurozone funds to provide the Spanish government with $123 million to recapitalize its struggling banks. Conservative, pro-austerity Prime Minister Mariano Rajoy defeated Socialist leader Jose Luis Zapatero in 2011, but may himself be ousted by the new left-wing party Podemos later this year. In France, the May 2012 election of Socialist President Francois Hollande brought a government less willing to undertake structural reforms even as recession hit, unemployment approached 11 percent, and the country’s competitive position weakened.

Watch: The European Debt Crisis Visualized

In early 2013, Cyprus’s massively unbalanced banking sector collapsed, as foreign capital fled and left much of the financial sector insolvent. The 2012 “haircut” taken by private holders of Greek debt exacerbated the panic, as Cypriot banks held many of those devalued Greek bonds. In March 2013, Cyprus received a $13 billion bailout that required the country's largest bank, Laiki, to close, forcing heavy losses on wealthy depositors.

Fragile Recoveries

By 2014, periphery countries, with the exception of Greece and Cyprus, had completed their bailout programs. In December 2013, Ireland was the first country to exit its program. Spain followed in January 2014, and Portugal too exited in May 2014. Growth in the periphery resumed: Ireland is set to be the fastest growing eurozone economy in 2015, having expanded 5 percent in 2014. Portugal is expected to expand 1.5 percent in 2015, and Spain’s economy has been growing since 2013.

But deep structural problems persist, including stubbornly high unemployment, weak banking systems, huge debt, and rigid labor markets. Spain, for instance, has begun reforming its labor markets, and the country added jobs in 2014. However, unemployment remains above 23 percent—youth unemployment is above 50 percent—and many experts argue that Spain’s banks are still weighed down by bad assets. Similarly, Ireland and Portugal have racked up public debts above 120 percent of GDP in the course of their bailout programs, and both struggle with double-digit unemployment. Youth unemployment across the entire eurozone has reached 23 percent, threatening to create a “lost generation.”

Greece underwent years of economic and political turmoil only to emerge again as a crisis point in 2015. In July 2013, then-Prime Minister Antonis Samaras’s center-right government had pushed through a painful package of wage cuts, public layoffs, tax increases, and privatizations that allowed Greece to return to international financial markets by April 2014. By the end of 2014, the country was growing by almost 2 percent, and had achieved a budget surplus.

Still, conditions remained dire: The Greek economy had contracted by a quarter, unemployment held at 25 percent, and the debt load (now mostly owed to the public sector) reached 175 percent of GDP. Anti-austerity political movements on both the Right and Left gained popularity, and in the national election in January 2015, the leftist Syriza party won a resounding victory. Syriza Prime Minister Alexis Tsipras immediately confronted the EU over renegotiating the terms of Greece’s bailout—a move which, some fear, could lead to default and an exit from the eurozone.

Reforming the EU

In the wake of these crises, support for “euroskeptic” parties has risen, from the right-wing National Front in France to left-wing Podemos in Spain, while the EU has launched reforms to improve governance and coordinate economic policy. In 2011, EU leaders agreed to a German-backed fiscal union that allows Brussels to dictate national budgets, and 2012 began the process of creating a eurozone-wide banking union.

The ECB has been at the center of the EU’s institutional development, given the centrality of monetary policy to reviving the bloc’s economies. In 2012, the bank unveiled a program that allows it to buy up potentially unlimited government bonds, a move that brought down the borrowing costs of indebted sovereigns following Draghi’s pledge to do “whatever it takes” to preserve the euro.

By 2015, amid threats of deflation, Draghi announced a European version of the unorthodox monetary policy known as quantitative easing, or QE. Under the plan, the ECB will buy $1.3 trillion worth of assets in an effort to avoid a downward spiral of falling prices and deferred consumer spending. Deflation is exacerbating the eurozone’s low demand, low investment, and weak lending, making reestablishing growth extremely difficult and leading the IMF to downgrade the region’s prospects for 2015 and 2016.

The ECB has found such aggressive measures necessary due to the weakness of Europe’s core economies. While the periphery recovers, the “big three” economies of Germany, France, and Italy are all barely growing or, as in the case of Italy, have fallen into outright recession. France and Italy, meanwhile, continue to struggle to implement their own structural reforms. Both economies failed to meet EU budget and deficit targets for 2015, again highlighting the tension between the demands of Brussels and the political realities of its member states.

Additional Resources

Brookings President Strobe Talbott looks at European integration through the prism of a seminal EU founding father, Jean Monnet, in this essay.

Franco Pavoncello, President of Rome’s John Cabot University, reviews the implications of the decision to create a common European currency in this essay in World Affairs.

This CFR Interview with Eurasia Group President Ian Bremmer delves into Greece’s potential for deepening the European crisis.

CFR's Benn Steil and Dinah Walker argue that the ECB's bank stress tests will roil rather than calm markets if recapitalization funds are not set aside in advance in this 2014 Policy Innovation Memorandum.